Tuesday, May 2, 2017

Douthat and Feldstein on Euro

In case you missed it, this Sunday featured a creditable effort by the NY Times to look out of the groundhog hole. You have likely followed the explosion resulting from Bret Stephens' first column. Likewise, Ross Douthat tried to explain the attraction of Marine LePen. I'm not a LePen fan, but appreciated his honest effort to explain how the other side say things.

I was interested in Douthat's views on the euro:

But on the other hand, our era’s “enlightened” governance has produced an out-of-touch eurozone elite lashed to a destructive common currency,..

There is no American equivalent to the epic disaster of the euro, a form of German imperialism with the struggling parts of Europe as its subjects...

And while many of her economic prescriptions are half-baked, her overarching critique of the euro is correct: Her country and her continent would be better off without it.

Douthat does not pretend to be an economist, and I have no beef with his expressing such views. Because such views are commonplace conventional wisdom from our policy elite. And if the euro falls apart, they will bear a lot of blame for its passing. Be careful what you write, people might be listening. No, when Germany sends Porsches to Greece in return for worthless pieces of paper, it is not Germany who got the better of the deal. And while you're at it, get rid of that silly common meter, and restore proper nationalism of weights and measures too. (Of course perhaps my admiration for the euro is wrong. Then they will deserve credit for the wave of prosperity that flows over Europe once it unleashes the shackles of the common currency dragging it down. )

As a concrete example, consider Martin Feldstein writing in the Il Sole series on the Euro, (I don't mean to pick on Feldstein. He has been a consistent anti-euro voice, arguing the great benefits for Italy and Greece of periodic inflation and devaluation. But he is just a good sober example of the common view in Cambridge-centered economic policy circles.)

Topic sentences:

Although Italy was an enthusiastic adopter of the euro when the single currency began, the Italian experience of the past decade suggests that was a mistake.

...it seems plausible that Italy’s economy would be in better condition today if Italy, like Britain, had decided to keep its own currency and therefore to be able to manage its own monetary policy and its own exchange rate.

Analysis:

Advocates of adopting the euro argued at the time that members of the Eurozone would be forced by market pressures to converge to a high common level of productivity and a corresponding level of real wages. That never happened. Instead, Germany powered ahead with rising productivity that has resulted in real per capita income 30% higher than Italy’s, an unemployment rate that is less than half Italy's and a trade surplus that is 8 % of its GDP.

Huh? It is a new proposition in monetary economics to me that adopting a common currency forces countries to move to common productivity, any more than adopting the meter forces countries to do so. Alabama and California share a currency and not productivity. Fresno and Palo Alto share a currency and not productivity. A common market in products with free movement of capital and labor might force out economic, legal, and regulatory inefficiency, but that would happen regardless of the units of measurement.

The most basic proposition in monetary economics: The choice of monetary unit has no effect on long-run productivity or any other aspect of the long-run real economy. Using the euro vs. the lira has no effect on long-run productivity, any more than using the meter forces Italian tailors to cut Norwegian-sized suits, or that using the Kilo forces Italian restaurants to serve bratwurst and beer rather than pizza and wine.

The countries that adopted the euro never satisfied the three conditions for a successful currency union: labor mobility, flexibility of real wages, and a common fiscal policy that transfers funds to areas that experience temporary increases in unemployment.

This is another repeated truism. In my view the main condition for a currency union was present in the euro and the problem was forgetting about it when the time came. In a currency union without fiscal union, bankrupt governments default just like bankrupt companies. Neither labor mobility (which exists in Europe), flexibility of real wages (doubtful in the US) or common fiscal policy (also limited in the US) are necessary. Europe lived under a common currency -- the gold standard -- for hundreds of years. Sovereigns defaulted.

I suspect Feldstein means by "common currency" far more than I do. I mean, we agree to use a common currency. I suspect Feldstein means far more than that, including that no government debt may ever default and that the ECB must print money to ensure that fact. Like all disagreements perhaps this one simply reflects a difference in meaning of the words. If so, it would be good to say so. Objections to "the euro" are not objections to a common currency per se, but objections to the rest of the legal, regulatory, banking, fiscal, and policy framework that accompanies the euro.

To be fair, there is also a different underlying world view here. In Feldstein's world, national governments and central banks can be relied on to diagnose "shocks," and artfully devalue currencies just enough to "offset shocks" when and only when needed; in the european case likely imposing "capital controls" as well, but to do this rarely enough that investors will still buy government bonds, invest in their countries, and avoid the slide to banana republic inflation, repression, and trade and investment closure. In my world, as I think in the real world of Italy and Greece before the euro, national currencies are not such a happy tool of benevolent dirigisme. The commitment not to devalue, inflate, and grab capital after the fact is good for growth and investment before the fact. A government sober enough to use Feldstein's tools wisely is also sober enough to borrow wisely when offered low rates. A government not sober enough to borrow wisely when offered low rates is not sober enough to artfully devalue, inflate, grab capital "just this once" in response to shocks.

21 comments:

Sovereign default doesn't seem to be a practical option when the banks are in a "doom loop" with large holdings of bonds issued by the home government. I agree with your post of August 19, 2015 that criticizes this flawed model of banking that is used in Europe.

Yes! I was going to say that but the post got long. There is nothing in using a common currency that forces banks to hold mounds of domestic government debt. In fact, this will likely be an even more prevalent feature of a return to Lira and Franc. Governments like to prop up currencies by making banks hold them, and the whole "capital controls" crowd will encourage it.

Would UK have been better off over the past 16 years if it had adopted the euro? I think not. Apparently, the English don't think so either.

The euro project has failed. The EU has failed. Some of the chaos in Europe comes from having full labor mobility without a common immigration policy. They adopted a single currency, but had no centralized euro version of the FDIC or bank regulators. Unlike the federal government in the US, the EU has no central government authority which engages in interstate transfers. Imagine Florida had a stand-alone Social Security system. Imagine states received no Medicaid or unemployment transfers.

Imagine that the EU existed but had no euro in 2008. Would Europe be in better shape or worse shape now? I think much better shape.

Admittedly, such pessimism sells. For certain reasons people like to hear that the world is going to hell, and become huffy and scornful when some idiotic optimist intrudes on their pleasure. Yet pessimism has consistently been a poor guide to the modern economic world. We are gigantically richer in body and spirit than we were two centuries ago. United balances stronger.

John, I completely agree with your analysis. But I am afraid the setup you describe was the original design of European Monetary Union (EMU) of the late 1970s, not the one that emerged after 2009 when the sovereign debt crisis hit Southern Europe.IMHO the Monetary Union was originally designed as a monetarist experiment: countries would get rid of the tempting tools of monetary-policy and exchange-rate-policy "fine tuning". And sure, the eagerness of Southern European countries to adopt the euro was the result of the fact that monetary policies and exchange rate policies had failed so spectacularly in the 1970s and 1980s there. Spanish peseta devaluation of the 1970s and 1980s, e.g., didn't help Spain at all. Self-enforcing inflation dynamics resulted in real peseta appreciation in the period between the end of Bretton Woods and 1999, while the German real effective exchange rate roughly stayed constant during the same period - as Deutsch Mark appreciation was offset by low German inflation. Southern Europe of that time was the master example of the failure of the policies Feldstein proposes. Isn't it astonishing how quickly people forget about that?!For the "monetarist" setup of the euro, however, the no-bailout clause (Art. 125 of the Lisbon Treaty) is a necessary condition. The current status is non-sustainable, because fiscal risks and political responsibilities don't match. German politicians frequently blame the Italian electorate for voting "irresponsibly", which understandably sets up Italians, but the German reaction is understandable as well, as Germans would share the fiscal risks if Italian political experiments would fail and bailout mechanisms would get triggered. Unfortunately the no-bailout clause was abandoned the first time it was needed (in March 2010, when Greece got into its fiscal crisis). Now all this mess is creating nationalism, which prevents the other sustainable solution: a fiscal and political union (de facto a kind of United States of Europe), where fiscal responsibilities and political influence would match again.BTW: The initial construction bug was the "fiscal rules" (which limit EMU countries' fiscal scope with a nonsense set of restrictions). They were added to the original EMU design in the 1980s. You don't need such rules if you have a no-bailout clause. Once they were included into the EMU design nobody took the no-bailout clause for earnest. As a result all country-specific risk premia vanished in the run up to 1999.To sum up: I agree that a successful monetary union between sovereign countries is possible, but only with a strong no-bailout clause.

I agree entirely. Well written. The problem is not the common currency, or even the design of the euro. It is the failure to follow that design when some big German and French banks might have lost money on Greek debt. You are additionally wise to point out the weakness of the deficit limits. If we are not going to bail out, and if sovereigns are going to default, then who cares what deficits you run? The deficit limits signal that we will be tempted to bail out after all.

For the rest of readers, it is perfectly possible to have a currency union without sovereign bailouts. US states have defaulted, and may again.

If the issue under discussion is that a sovereign bailout regime without fiscal union is unsustainable, then indeed it is. But let's call it that and not masquerade about currency choice.

Unfortunately it is a common perception that the participation of nations like Greece in the monetary union has put them at the mercy of Germany. For obvious reasons, voices in the UK keep amplifying this viewpoint. However, I too am of the mindset that participation in the union has nothing to do with it. Every country that accepts emergency lending to fend off a bankruptcy has to agree to certain condition. Argentina had to accept conditions set by the IMF in the 1990s in exchange for a bailout, and so on. I think the problem is that some circles in Germany, like Finance minister Scheuble, who had always been skeptical regarding Greece's participation in the monetary union, set particularly stringent conditions hoping that Greece would choose to abandon the Euro instead. In my opinion, that would have been much more costly for both Greece and the rest of the EU.

The political decision, and perhaps for good reasons (e.g. fear of contagion, etc.), seems to be that a country member should not be allowed to default. Adhering to this decision means that there need to be fiscal rules in place that ensure the sustainability of government debt for each country in the long run. Economic theory tells us that this depends, in turn, on the size of the primary surplus or deficit and the difference between the rate of interest on the debt and the rate of GDP growth. However, the interest rate is subject to speculative attacks which can lead to self-fulfilling prophecies. Hence, there needs to be a way for the EU to set an interest-rate ceiling, perhaps by acting as a lender of last resort at a set interest rate for any member-state that faces a speculative attack but meets the criteria for debt sustainability in the long-run. This is not a bailout, just like a discount loan to a bank facing a bank-run is not a bailout.

"Adhering to this decision means that there need to be fiscal rules in place that ensure the sustainability of government debt for each country in the long run. Economic theory tells us that this depends, in turn, on the size of the primary surplus or deficit and the difference between the rate of interest on the debt and the rate of GDP growth."

Economic theory also teaches that capital markets are composed of both debt (presumably risk free) and equity. There is nothing in economic theory that says a government must finance deficits with the sale of bonds / debt. Also, there is nothing in economic theory that says that the sale of any security by a government is contingent on a deficit existing. It is perfectly acceptable for governments to sell bonds / other securities during years of surplus.

Ultimately, I call it political short sightedness worsened by economic ignorance and banks dependent on government debt sales.

Politicians assume that individuals are not willing to knowingly buy risk bearing (equity) securities from a sovereign. And that is reinforced by economists claiming that sovereigns should inflate (Feldstein, Douthat) or default (Cochrane) on their debts.

There have been numerous recommendations on the use of contingent sovereign securities. For instance:

My personal favorite is fixed term, zero coupon securities that can ONLY be used to discharge a tax liability.

The discount rate would be set in relation to the output gap. In that way you get countercyclical policy action (higher discount rates are given for larger output gaps) and you get pro cyclical returns on those securities (higher growth rates allow investors to realize larger returns on investment).

You are not taking into account the ten years of history that proceeded the debt problem. Critics of the way the euro operates identify that it allowed the debt to build up with cross continent financial contracts and imbalances that would otherwise not have been possible. These economics are acknowledged in new Brussels regulations the "Macro Economic Procedure."

"Critics of the way the euro operates identify that it allowed the debt to build up with cross continent financial contracts and imbalances that would otherwise not have been possible."

No, that is a fiscal problem with the Maastricht Treaty, not a problem with the Euro:

https://en.wikipedia.org/wiki/Maastricht_Treaty

Notice that the treaty focuses on both deficits and debt. The debt is the problem because it enables countries like Greece to finance expenditures in excess of what the country produces and exports. Deficits are manageable as long as they are internally financed.

See above for my ideal government equity.

"My personal favorite is fixed term, zero coupon securities that can ONLY be used to discharge a tax liability."

With government equity in this form, the only logical buyer is domestic. A German bank would have no reason to buy Greek equity of this form because the German bank does not pay Greek taxes.

Contrast that with GDP linked bonds (see wikipedia article above) or Trills (recommended by Shiller) where a country could sell them internationally and then severely understate it's growth rate.

The thesis is that the novel built up of debt and trade immbalances was because the contracts were in euro without a currency barrier, and with the ECB providing liquidity.This is acknowledged after the event by the emergence of the Macro economic Procedure and the Macro economic Stabiliser regulations set up to attend to such dynamics.

"The thesis is that the novel built up of debt and trade immbalances was because the contracts were in euro without a currency barrier, and with the ECB providing liquidity."

That is certainly one way (abeit the wrong way) to look at things.

On trade:

When one country's currency weakens against another's, that makes everything in the weak currency country less expensive to buy for the stronger currency including tradable goods, stocks, bonds, land, buildings, etc. So to say that a country like Greece would have been able to straighten out it's balance of trade by having it's own currency ignores the obvious.

On debt:

As I described above, the most straightforward way to limit debt is to sell equity instead.

"Because such views are commonplace conventional wisdom from our policy elite. And if the euro falls apart, they will bear a lot of blame for its passing."

Oh, come on. First, the US chattering class does not have that much power. Few people in the US listen to them. Second, if the Euro collapses it will be because of its internal defects and the mismanagement of its bankers. The spectators neither win nor lose the game. They are just spectators.

This might not be too relevant. But if you compare budget deficits in El Salvador after and before dollarization was adopted in 2001, you see amarked change on average. General government primary deficit went from -0.3% of GDP on average on 1990-2000 to -1.22% in 2001-2016.

It is not perhaps too radical a change, but it might indicate one of the problems of a currency union: the government of El Salvador, devoid of monetary policy, is trying to stabilize the economy with hte only tool left to it, that is, the fiscal tool.

You say that neither labor mobility nor a common fiscal policy (that transfers funds to areas that experience temporary increases in unemployment)are necessary for the EMU to work.

I agree with that.

The basis of a monetary union is the agreement of all member states on a uniform development of the price level across the member states and nothing (!) else.

The problem is: when Unit Labour Costs and prices across member states have been allowed to substantially diverge, the realignment of relative prices is extremely painful when you do not have either fiscal transfers or a high degree of labour mobility (where, e.g., unemployed Spanish workers can easily move to Germany).

That is, ensuring that Unit Labour Costs and prices across member states develop in line with inflation in the EMU as a whole is the only condition that needs to be fulfilled for the EMU to work. But once this fundamental basis for the functioning of a monetary union has been ignored, a lack of labour mobility (and I would argue that, due to language barriers, labour mobility within the EMU is in fact significantly restricted) and a lack of fiscal transfers threaten the survival of the EMU because member states are, of course, tempted to avoid the cost of ‘internal devaluation’ by leaving the currency union (i.e. by devaluing externally instead).

Given that (due to lack of labour mobility and lack of fiscal transfers) a realignment of wages and prices is so costly, the EMU needs a mechanism to prevent asymmetric shocks from leading to substantial differences in Unit Labour Costs between member states.

Given that member states don’t have their own monetary policy any more, fiscal policy is the only tool left to achieve such a mechanism. That is, instead of the nonsensical 3% deficit limit, there should be a fiscal rule requiring member states to set the budget balance in such a way that Unit Labour Costs and prices develop in line with inflation in the EMU as a whole.

Using fiscal policy in such a way involves inefficiencies and may not work anyway. But in my opinion, it should at least be tried because the EMU’s current framework virtually guarantees failure.

I have a beloved and extremely intelligent Marxist friend who says to me, “Ihate markets!” I reply, “But J, you delight in searching for antiques in markets.” “I don’t care. I hate markets!”Poanta (crux)? brgds

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!